Redefining Fair Market and Effective Rates
What is a “fair market” value?
In its simplest form, fair market value is an amount a ready, willing, and able individual would pay to use or purchase something. Sound simple? If you’ve been reading our Tenant Tactics over the years or just new to Tenant University, you know nothing is simple when it comes to the interpretation a landlord has of the even the most minute detail—especially when that detail is in the landlord’s favor. While fair market value is as defined above, there’s a little quirk that tenants need to watch out for when their landlord lays something on them that’s tied to fair market value.
Real estate is different.
A real estate salesperson must work exclusively with a broker. According to the tax code, he/she is therefore considered an employee. This is not necessarily true in real estate. In most states, the broker is considered to be an independent contractor. Make sense? Not really, but it’s how real estate works.
When you look at market value, you need to compare apples to apples. If the landlord was to rent the space to a third party (e.g. a new tenant), you need to look at not only what the rate would be, but also at what went into that rate. Here is an example of how two leases of $2.00 per square foot per month can be radically different.
Case A: The tenant went into a highly improved space. Other than repainting the space and putting in new carpet, the landlord simply handed off the keys to the tenant who signed a five-year lease.
Case B: The space was in need of repair beyond repainting and re-carpeting. Further, the tenant wanted to upgrade the conference room and lobby area. The landlord was more than willing to amortize the cost of over-standard improvements into the five-year rental term. The difference between the two cases is that in Case A, the tenant found the space by calling the sign in front of the building, while in Case B the tenant hired a broker to represent them. The tenant in Case B received more particularized service.
What is the market value of each deal?
Here’s some lease language we like to see which helps define FMV:
(c) The term "fair market rental rate" shall mean the annual or monthly rental amount per rentable square foot, projected during the relevant period, that a willing, comparable, non-equity tenant (excluding sublease and assignment transactions) would pay, and a willing, comparable landlord of a comparable quality office building located in the _______________________ area ("Comparison Area") would accept, at arm’s length (what the landlord is accepting in current transactions for the building shall also be considered), for space comparable in size, quality and floor height as the leased area at issue. The calculation is also taking into account the age, quality and layout of the existing improvements in the leased area at issue and also taking into account items that professional real estate brokers customarily consider. These include (but are not limited to) rental rates, office space availability, tenant size, tenant improvement allowances, operating expenses and allowance, parking charges, broker fees, free rent, free parking, and any other lease concessions, if any being charged or granted by the landlord or the lessors of such similar office buildings. The fair market rental rate will be an effective rate (average over the term), not specifically including, but accounting for, the appropriate lease concessions described above.